Markets: A cautionary note on junior debt

It seems to be ever so conflicting to be a shareholder and a taxpayer.

If it isn't taxpayers coughing up for ailing banks, investors would take the hit -- limiting Moody’s rationale for downgrading the subordinated debt of Australia’s banks. Significant retail ownership of the Big Four banks in Australia won’t provide taxpayers with protection in the unlikely event of a bail-in.

In a bid to have losses shared more evenly between bond holders and shareholders over taxpayers, ratings agency Moody’s has gone on a spree of downgrading the subordinated debt of Asia Pacific banks. In Australia, the Big Four had their subordinated debt ratings moved two notches lower to A2.

Ultimately, Moody’s is being reactionary in its concern that subordinated debt holders will be “bailed-in” and forced into an undesirable exchange for depressed equity. Or outright losses. Changing the rating on this debt isn’t going to change the outcome.

But this should serve as a reminder to investors there is risk with these debt offerings at the lower end of the scale. Whether it will cost the banks any more to raise subordinated debt in the open market is yet to be seen. The underlying credit rating of each of the banks remains stable and the quest for a premium above the cash rate should help get any required raisings away at a comparable cost to pre-ratings change. 

Increased costs to raise subordinated debt will either result in lower rates or higher fees for end users of bank products – or lower profits to be shared among investors.

International trends have seen bail-ins become the norm for distressed banks; the Eurozone and the UK banks are culprits. However, Australia’s financial system and bank operations are considerably more stable than the likes of some of their international peers.

The increasing importance of quality corporate governance practices has meant senior managers of each of Australia’s banks are remunerated in share holdings, in part eliminating the moral hazard.

In the event of a bail-in, stock prices would have already plummeted and additional equity shareholders would dilute existing holdings, devaluing them further. Not a desirable outcome for anyone involved. This is not to say managers aren’t taking some form of risk, but it is to their detriment to take unnecessary risk. 

Reports show asset quality for Australian banks improved during the June quarter. With Basel III now in place and the RBA’s Committed Liquidity Facility going live from 1 January 2015, the operating environment for Australian banks looks steady.

Overall, the lower rating on subordinated debt shouldn’t be problematic for any of Australia’s banks while their underlying credit rating remains stable.